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Roth IRA vs Traditional IRA vs 401(k)

Managing your finances is one of the most important things you can do as an adult. Having a good income is a great starting place. After that, you need to try and reduce debt but also save up an emergency reserve fund.

It's after you cover those bases that you can start thinking about saving not just for emergencies but for things you might like to do in the future. That can range from a new car or home to vacations, college for kids, and retirement. Your timelines can impact your savings a lot.

When it comes to saving and investing for the future, the biggest thing you need to do is just make sure you are actually doing it. Once you begin, however, you should take advantage of tax-advantaged investment vehicles whenever possible. Your options might include a traditional IRA, a Roth IRA, or a 401(k) plan.

Both IRAs should be available to you whether you are working for a company or not. The 401(k) plan is employer-sponsored, so you can only access it if you have a job. Even then, not all jobs offer the plan.

Traditional IRA

IRA stands for individual retirement account. You can fund it using pre-tax dollars out of your income into many different investment assets. Those assets can include stocks and bonds, but you can also do real estate, commodities, cryptocurrencies, and other things.

Your investment gains in the account don't get taxed while still in the IRA. You only get taxed on distributions or withdrawals that you make. How much you pay in taxes then is based on when and how you do those.

If you wait until age 59 1/2 or later, then you can pay reduced or even no taxes. The whole idea behind an IRA is to encourage people to save and invest specifically for retirement. That's why the tax benefits kick in at later ages.

There are two potential downsides to an IRA. First, annual contributions are often capped for how much you can contribute every year. Second, if you need the money before retirement, you would face taxes and early withdrawal penalties for accessing it before you are ideally supposed to.

Nearly anyone can set up an IRA, however. This is not an investment vehicle that requires you to be employed with anyone. That also frees you up to invest in whatever asset classes you choose, and that makes it easier to achieve the portfolio diversification you hope to have.

Roth IRA

A Roth IRA is a kind of IRA, but it doesn't work entirely like conventional or traditional IRAs. Roth IRAs are similar to other IRAs while they are active. However, the differences happen at the beginning and end.

While your investments are inside a Roth IRA, they grow without their gains being taxed. You also have just as many investment options in terms of asset classes as a traditional IRA. These are both similarities between Roth and conventional IRAs.

How a Roth gets started is the first primary difference. You can't fund a Roth IRA using pre-tax dollars. You have to use post-tax dollars to do it.

That might seem like the loss of a tax benefit that 401(k) and conventional IRA options have. However, the reason for it is that Roth IRAs aren't taxed at all when you make withdrawals or distributions after five years. Since everything was taxed going in, the taxes are assumed as already paid.

You get to enjoy tax-free gains for those five years. You also get to tap into your investments after just five years instead of waiting for retirement. The other plans don't let you do that.

401(k)

A 401(k) plan is a common benefit to many employment positions. They can be powerful resources for your to save and invest money with. However, they can also be really complicated.

These plans have serious tax advantages to them. Your contributions are done using pre-tax dollars, you don't pay taxes on the gains your investments make while in the account, and you can enjoy tax-free or tax-reduced withdrawals if you wait for retirement and do things right. You might even pay less in taxes during your working years since your contributions lower your tax bracket.

The flip side is that you'll only have the investment options your employer or plan administrator lays out for you. That's primarily going to be stocks and bonds. Mutual or index funds are very common.

Some employers offer extra perks, however. You might be able to take personal loans out against your investment balance. Also, many employers might match your contributions up to a certain percentage of your salary or wages, and that's free money you should take advantage of.

Which One Is Best?

Which one should you use? That depends on your circumstances. Personally, I like the traditional IRA because of how it gives you a wide variety of investment options and perhaps the best tax advantages but only if you're saving for retirement.

A Roth IRA isn't always as beneficial in terms of taxes. That's because it uses post-tax income. However, if you need the money before retirement but after five years, then this is a good mid-range option.

A 401(k) plan has tremendous tax benefits to it. The downside is limited investment options. However, you should never leave free money on the table if your employer has matching contributions.

One Final Tip

If you're thinking about investing in gold and other precious metals in the future, then you should know that a gold IRA offers serious tax advantages on top of the benefits of owning gold. Fortunately, you can fund a gold IRA with a rollover of a previous investment account. All three accounts I've discussed here are ones you can do a rollover with, and you can usually do them without paying any taxes or penalties on that transfer.

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